The PBOC, Interest Rates, the Stock Market, and Nominal GDP

The PBOC cut rates over the weekend and reserve ratios noting the significant amount of available money for lending.  A few brief thoughts.

  1. This was clearly aimed at the stock market drop of almost 20% in the last two weeks.
  2. Any stock market movement that depends a 25 basis point cut to sustain PE ratios above 100, clearly is driven by mania.
  3. Given the weekends events in Greece and the fear in the Chinese market, I don’t think you can count on a large bounce.
  4. While the stock market was clearly the target, given that real interest rates for even the most credit worthy SOE, any cut in real interest rates for any reason should be welcome.
  5. The PBOC is targeting lending ability but given the drop in loan demand, surplus capacity, and falling aggregate demand, they should be targeting interest rates rather than reserve ratios and loan to deposit ratios. This is simply bad policy.
  6. The more important aspect of all this will be the impact on the real economy and any impact of interest rates on the real economy. Given the very short duration of most Chinese debt any cut in interest rates would seem to impact profitability relatively quickly.  Furthermore, the stock markets impact on the real economy I believe is likely to be minimal.  The only places you saw evidence of the run up was in Beijing, Shanghai, and Shenzhen where real estate prices bounced.  The rest of country, as a comparison, continued to fall.
  7. Given the deterioration of GDP growth with real interest rates upwards of 10%, it seems that the PBOC is maintaining high rates to protect banks and other preferred firms. The carry trade with Chinese characteristics brings in billions of dollars a year for firms with the capabilities to carry it out and major Chinese banks are already under margin pressure due to interest rate liberalization with fixed deposit rates.  Cutting interest rates aggressively would really place enormous pressure on bank profitability.  Though they rank high for capitalization and profitability, given the rapidly rising bad loan, mentioned loans with the already extremely generous classification, and loan rollovers, there is reason to believe these banks are not nearly as healthy as claimed.  With even the state auditor noting that major Chinese SOE’s are falsifying revenue and profitability numbers with banks making questionable loans, you can be sure there are many more problems masked.  The monetary policy of the PBOC however is nothing short of abysmal.

All of this points to a larger problem about trying to grapple with the true state of the Chinese economy.  With HSBC pulling its sponsorship of the PMI index of manufacturing, everyone is trying to figure out how best to assess the state of the Chinese economy given the Beijing dictate that only positive news or data is allowed.  The Financial Times when writing about the Goldman Sachs attempt to measure Chinese GDP, quoted GaveKal with what can only be called the art school approach to economic accounting: “the debate about whether China’s GDP figures are overstated or understated is ultimately a waste of time as there is no way to know what is the ‘correct’ level of China’s GDP.”

If economics is not trying to measure and quantify and make rational decisions on the collected data, then it truly serves no purpose.  Government statisticians and investment bank economists should just get gold stars with smiley faces for their art projects about the state of the Chinese economy where nothing is ever wrong.

While I understand the frustration in trying to measure and understand the Chinese economy there are a number of important points to note.  First, even Chinese officials know and admit that they are being producing low quality data.  While they may not release the high quality data even if they have it, they know that they don’t have the data necessary to manage an economy with 1.3 billion people.  Just this week China announced an effort to better quantify the labor market with 120,000 statisticians equipped with tablets to roam the country conducting ongoing labor market surveys.  This problem is not lost on the highest reaches of Chinese leadership.

Second, we may not be able to quantify the past 30 years of Chinese GDP growth, but we absolutely need to understand the direction of the current economy something many appear unwilling to take a position on.  While I openly believe Chinese GDP growth is significantly lower than official reports, compiling a wide range of metrics, there is little evidence of almost any sector of economic activity in China growing at 7% a year.  While I have previously noted that electricity growth for the first 5 months of 2015 was up only 0.2% YOY, even the Chinese finance minister is grousing about tepid tax revenue growth of 2%.  To provide some perspective, the PBOC just lowered its official growth estimate from 7.1% to 7% and the MOF had estimated tax revenue growth of 7% but so far has only seen 2%.  Assuming the data is accurate this implies that a drop from 7.1% to 7%, or 0.1%, resulted in a drop in tax revenue growth from 7% to 2%.  That is some amazing growth to tax revenue elasticity.  There is no secondary data evidence that China National Bureau of Statistics GDP data is anything other than a pretty art project that deserves a red star.

Third, quantifying the Chinese economy helps us understand the risks. As the Financial Times again points out, official nominal GDP, which you believe at your peril, has fallen from 20% growth in 2011 to under 6% in the first quarter this year.  Given that debts and tax revenue are paid in nominal revenue rather than real revenue, this matters enormously.  This means that nominal GDP has fallen nearly 75% with “average revenue growth for listed companies slump(ing) from nearly 30% expansion in the first quarter of 2011 to just 0.7% in the first quarter.”  This makes the existing debt load that much less bearable.  This means the risks to the stock market, listed companies, banks and China are much higher than understood.  Given that there is strong documented evidence that inflation has been systematically underreported, this negatively impacts our expected risk level.

If you remember nothing else from the attempts understand the Chinese economy, remember two things using official data.  First nominal GDP in China has fallen almost 75% from a few years ago.  Second, 7% is currently only being attained by relying on deflation.  Neither are indicators of a healthy economy so imagine what the real data looks like.